PS7/25 – Update to PS9/24 on the SME and infrastructure lending adjustments

1: Overview

1.1 This Prudential Regulation Authority (PRA) near-final policy statement (PS) provides the PRA’s near-final policy on the SME and infrastructure lending adjustments to Pillar 2A (Pillar 2A lending adjustments) as outlined in PS9/24 – Implementation of the Basel 3.1 standards near-final part 2 and following consultation on its original proposals in CP16/22 – Implementation of the Basel 3.1 standards.

1.2 This near-final PS has been published alongside CP12/25 – Pillar 2A review – Phase 1, which sets out the PRA’s proposed updates to Pillar 2A methodologies and guidance to address the consequential impacts of the near final PRA rules that would implement the Basel 3.1 standards.

1.3 This near-final PS is relevant to PRA-authorised banks, building societies, PRA-designated investment firms, and PRA-approved or PRA-designated financial or mixed financial holding companies within the scope of application of the PRA’s implementation of the Basel 3.1 standards as set out in chapter 2 of PS17/23 – Implementation of the Basel 3.1 standards near-final part 1 (firms). This near-final PS is not relevant to credit unions.

1.4 In CP7/24 – The Strong and Simple Framework: The simplified capital regime for Small Domestic Deposit Takers (SDDTs), the PRA proposed to apply the Pillar 2A lending adjustments to SDDTs. The details on the Pillar 2A lending adjustments for SDDTs, including changes to relevant policy materials, will be set out when the PRA finalises the simplified capital regime for SDDTs.

1.5 The PRA’s near-final methodology for setting the Pillar 2A lending adjustments for firms, as well as the data templates and accompanying instructions required for its calculation are set out in the following appendix to this near-final PS:

• Near-final amendments to statement of policy (SoP) – The PRA’s methodologies for setting Pillar 2 capital (Appendix 1).^{footnote [1]}

Implementation and next steps

1.6 The policy material in this near-final PS is published as near-final. The PRA does not intend to change the policy or make substantive alterations to the instruments before the making of the final policy material.^{footnote [2]}

1.7 The near-final policy in this near final PS will take effect on the same date as the PRA’s implementation of the Basel 3.1 standards.^{footnote [3]}

1.8 Any references related to the UK’s membership of the EU in the SoP covered by the near-final policy in this near-final PS will be updated as part of the final PS to reflect the UK’s withdrawal from the EU. Unless otherwise stated, any remaining references to EU or EU-derived legislation are to the version of that legislation which forms part of assimilated law in the UK.^{footnote [4]}

2: Pillar 2A lending adjustments

Background

2.1 As set out in PS9/24, the PRA has decided to maintain its proposals to remove the SME support factor^{footnote [5]} and the infrastructure support factor^{footnote [6]} under Pillar 1. However, the PRA recognises concerns raised by respondents to CP16/22 on the potential impact on UK competitiveness and growth of even limited changes in capital requirements for SME and infrastructure lending. Consequently, the PRA decided to introduce the Pillar 2A lending adjustments to minimise any potential disruption to SME and infrastructure lending, and therefore growth, resulting from the removal of the support factors. This will ensure that the removal of the support factors under Pillar 1 do not cause an increase in overall capital requirements for SME and infrastructure exposures.

2.2 The PRA will implement the Pillar 2A lending adjustments for firms that submit the necessary data to the PRA (see Reporting requirements section below for more details).

Scope of eligible exposures

2.3 The PRA will calculate the SME and infrastructure lending adjustments for exposures that meet the eligibility criteria set out in ‘Instructions for Pillar 2 SME lending adjustment & infrastructure lending adjustment data templates’ (set out in Appendix 1 of the near-final SoP – The PRA’s methodologies for setting Pillar 2 capital published alongside this PS).The eligibility criteria are based on the criteria for the SME support factor and Infrastructure support factor set out in Articles 501 and 501a of the CRR respectively (prior to their revocation) and the PRA’s previous supervisory expectations on the implementation of the support factor. This includes the PRA’s expectation that the SME support factor, and therefore lending adjustment, should not be applied where the purpose of the borrowing is to support buy-to-let business as set out SS13/16 - Underwriting standards for buy-to-let mortgage contracts.^{footnote [7]}

2.4 The Pillar 2A lending adjustments will cover eligible exposures arising both prior to, and after, the PRA’s implementation date for the Basel 3.1 standards (day 1).

2.5 Exposures that simultaneously satisfy the eligibility criteria for both the SME and infrastructure support factors will be eligible for both the SME and infrastructure lending adjustments.

Approach to calculating the Pillar 2A lending adjustments

2.6 The Pillar 2A lending adjustments will be firm-specific and calibrated to hold a firm’s overall capital requirements^{footnote [8]} for SME and infrastructure lending constant compared to the situation in which the support factors had remained in Pillar 1 under the PRA’s implementation of the Basel 3.1 standards. The calculation is as follows:

2.7 The ΔRWA measures the impact on a firm’s RWAs arising from the removal of the SME and/or infrastructure support factors for purposes of the Pillar 2A lending adjustments.

2.8 The capital adjustment factor (CAF) is a firm-specific multiplier, reflecting the firm’s capital requirements, that converts ΔRWA into the Pillar 2A lending adjustments amount.

2.9 The PRA will calculate the Pillar 2A lending adjustments for firms as part of their C-SREP, except for the day 1 Pillar 2A lending adjustments, which will be calculated as part of the PRA’s off-cycle review of firm-specific Pillar 2 capital requirements.^{footnote [9]}

2.10 Consistent with the PRA’s existing approach, Pillar 2 capital requirements set for firms are subject to the PRA being satisfied that the firm maintains an adequate level of capital resources needed to comply with rule 2.1 of the Internal Capital Adequacy Assessment Part of the PRA Rulebook (overall financial adequacy rule).

Methodology for calculating ΔRWA

2.11 ΔRWA will generally be calculated as the difference between:

• the RWAs calculated under the PRA’s implementation of the Basel 3.1 standards (Pillar 1 RWAs); and
• the same Pillar 1 RWAs multiplied by the relevant support factor(s).

2.12 The PRA considers that this approach will ensure that the Pillar 2A lending adjustments only address the removal of the support factors, without materially undermining the improved risk-sensitivity for SME and infrastructure lending introduced under the Basel 3.1 standards. In addition, this approach avoids introducing the unnecessary complexity of requiring RWAs to be calculated under both the PRA’s implementation of the Basel 3.1 standards and the CRR requirements. The general formula is as follows:

ΔRWA (for relevant Pillar 2A lending adjustment) = ∑ [Pillar 1 RWA for eligible exposure – (Pillar 1 RWA for eligible exposure * relevant support factor multiplier)]

2.13 The general methodology for calculating ΔRWA applies to all eligible exposures regardless of the approach used to calculate credit risk RWAs, except for limited cases of exposures under the SA or the IRB slotting approach, as set out below.

2.14 In a limited number of cases, the general methodology for calculating ΔRWA is adjusted where the Pillar 1 risk weights have been lowered compared to the CRR risk weights such that the PRA considers applying the general methodology would result in:

• a double discount on overall capital requirements for such exposures, since both the lower Pillar 1 risk weights and the support factors target overlapping outcomes (this generally follows the approach taken by other jurisdictions to avoid a double discount between revised risk weights under the Basel 3.1 standards and the support factors); or
• overall capital requirements for such exposures that are materially lower than under the CRR requirements such that a further reduction in capital requirements would be imprudent based on the riskiness of the exposures.

2.15 The specific adjusted cases are set out below in Table 1 (for the SME lending adjustment) and Table 2 (for the infrastructure lending adjustment).

Treatment of recognised credit risk mitigation (CRM)

2.16 For SME and infrastructure exposures where CRM is recognised in the calculation of RWAs under the Basel 3.1 standards, ΔRWA will consider the application of the relevant support factor(s) to both the protected and unprotected parts of the exposure. This includes cases where the exposure (or protected part of it) receives a different risk weight due to the application of CRM (eg for exposures under the risk weight substitution method).

2.17 To calculate ΔRWA, the exposure will first be split into protected and unprotected parts. The ΔRWA will then be calculated separately for each part using the same methodology as for exposures without recognised CRM – ie by summing the difference between the Basel 3.1 RWAs and the Basel 3.1 RWAs with the relevant support factor(s) applied, unless the exposure (or the risk weight applied) falls under the adjusted cases set out in Tables 1 and 2 above.

Capital adjustment factor

2.18 Variable Pillar 2A requirements and the PRA buffer are typically determined as nominal amounts before being expressed as a percentage of total RWAs when set for firms as part of the C-SREP. Ahead of Basel 3.1 implementation, the PRA will conduct an off-cycle review of variable Pillar 2A and PRA buffer capital requirements.^{footnote [12]}

2.19 To align with the approach in the off-cycle review, the CAF formula for the day 1 Pillar 2A lending adjustments will cover the following components of the PRA’s capital stack:

• Pillar 1 minimum total capital ratio;
• Capital conservation buffer (CCoB);
• Countercyclical capital buffer (CCyB); and
• Systemic buffers.^{footnote [13]}

2.20 Following the off-cycle review of firm-specific Pillar 2 capital requirements, the approach will be adapted as follows, to align with the PRA’s C-SREP approach:

• Variable P2A will be assessed and set in nominal amounts as part of the C-SREP before being expressed as a percentage of total RWAs; and
• PRA buffer deductions for the CCoB and relevant CCyB will be included in the CAF formula.^{footnote [14]} This is to avoid a double impact from: (i) a reduction in the PRA buffer due to the increase in the CCoB and CCyB arising from the removal of the support factors; and (ii) the Pillar 2A lending adjustments themselves addressing the increase in the nominal amount of CCoB and CCyB.

Interaction with the output floor

2.21 The methodology used to calculate the Pillar 2A lending adjustments will be based on the underlying approach used to calculate the RWAs for SME and infrastructure lending, irrespective of whether a firm is bound by the output floor.^{footnote [15]} The PRA will not require a firm’s Pillar 2A lending adjustments to be recalculated as a result of becoming bound by the output floor.

2.22 The PRA considers its treatment of firms that are bound by the output floor is consistent with the nature of the output floor as an aggregate backstop measure aimed at addressing issues of variability, accuracy, and consistency in Total RWAs, rather than by type of exposure. In addition, the PRA considers this treatment to be consistent with its statement on the application of the output floor to minimum requirements and buffers set out in paragraph 5.47 of PS9/24, which stated that it does not expect or require firms, when becoming bound by the output floor, to change the granular risk-weights used for the purposes of calculating individual components of Pillar 2A.

Reporting requirements

2.23 In the Pillar 2 SoP, the PRA will publish the necessary data templates and accompanying instructions that are required for the calculation of the Pillar 2A lending adjustments. The PRA will implement the Pillar 2A lending adjustments for firms that submit the necessary data for eligible SME and/or infrastructure exposures, providing a breakdown of RWAs by: parts of the exposure amount that are unprotected and protected;^{footnote [16]} the relevant exposure class the exposure is assigned to; the corresponding risk weight that is applicable;^{footnote [17]} and the amount of support factor(s) associated with such exposures.

2.24 For the day 1 Pillar 2A lending adjustments, firms will need to submit the completed data templates as part of the PRA’s Basel 3.1 data collection exercise for off-cycle review of firm-specific Pillar 2 capital requirements.^{footnote [18]} The PRA will align these data templates and the applicable instructions with those published in the Pillar 2 SoP.

2.25 Following the one-off day 1 Pillar 2A lending adjustments, firms will need to return the data templates for the Pillar 2A lending adjustments alongside their ICAAP submission, following the same frequency as their C-SREP.^{footnote [19]} Firms do not need to submit the data templates if they do not want to apply either the SME lending adjustment or the infrastructure lending adjustment. 

PRA objectives analysis

2.26 Where implementing the Basel 3.1 standards further to the consultation in CP16/22, the PRA is required to comply with various legal obligations that applied before FSMA 2023 and not various ones introduced by that Act.^{footnote [20]} The PRA considers its analysis of its objectives relating to the near-final policy on the SME and infrastructure lending adjustments, as presented in PS9/24, remains appropriate. To provide clarity, this analysis is set out below.

2.27 The PRA considers that the SME and infrastructure lending adjustments will advance its primary objective in a proportionate manner. The PRA’s decision will ensure that Pillar 1 capital requirements are prudent and risk-sensitive, while minimising any disruption to SME and infrastructure lending and thereby support UK growth while maintaining an appropriate overall level of capitalisation.

2.28 The PRA considers that its decision to apply the SME and infrastructure lending adjustments is consistent with its secondary competition objective given it will be available to all firms with eligible exposures, regardless of the credit risk approach used.

‘Have regards’ analysis

2.29 In developing this near-final policy, the PRA has had regard to the FSMA regulatory principles and aspects of the Government’s economic policy as set out in the HMT recommendation letter of November 2024. The PRA considers its analysis of its 'have regards', as presented in PS9/24, remains appropriate. To provide clarity, this analysis is set out below:

1. Relative standing of the UK as a place for internationally active firms to operate and competitiveness:

• The PRA considers the SME and infrastructure lending adjustments will support the competitiveness of UK firms by striking an appropriate balance between delivering prudent Pillar 1 capital requirements that align with international standards and maintaining an appropriate overall level of capitalisation.

2. Finance for the real economy and sustainable growth:

• The PRA considers the SME and infrastructure lending adjustments should address concerns raised by respondents to CP16/22 on the potential impact of even limited increases in capital requirements on SME and infrastructure lending. The PRA considers that the introduction of these Pillar 2A lending adjustments will minimise any potential disruption to SME and infrastructure lending, and therefore the impact on growth, from the removal of the SME and infrastructure support factors.